Unmasking Fintech Mirage: Brace Yourself for Imminent Collapse of Financial House of Cards
Without a doubt, the Great Depression has nothing on the Global Financial Crisis of 2008. However, the fact that our vibrant startup community wouldn’t exist without it adds a touch of irony to the situation. The world’s central banks reduced interest rates to near zero in an effort to kickstart the economy.
Two outcomes can be derived from this. First, it encouraged financiers to put money into new technology startups, some of which turned out to be less than stellar. But it also made possible the formation of business concepts that would have been impossible under any other conditions.
The latter category is easily observable in the realm of financial technology. Over the past decade, a plethora of “challenger” banks, e-money services, digital wallets, and other competitors have emerged and successfully taken market share away from the traditional industry leaders.
They were successful because they provided a product that was, in the eyes of the target market, superior than the competition. These attractive apps, reduced or nonexistent costs, and increased refunds or interest rates were convincing to consumers. But they didn’t consider whether or not the underlying business models of these fintechs were long-term sustainable or could withstand a shift in macroeconomic conditions. They weren’t required to.
The fintech industry, however, must now confront the consequences of its actions. Interest rates have been steadily increased by central banks over the past two years, from their generational lows during the COVID era. And suddenly the consumer-loved business models appear increasingly precarious. The house of cards is doomed to fall at any moment.
One of fintech’s major flaws
Interchange fees are a major source of income for a wide variety of fintech companies. These are the fees that merchants must pay in order to process a credit card, debit card, or prepaid card transaction. Interchange fees are an important source of revenue for many fintech businesses, however the exact percentage varies from business to business.
The U.S. challenger bank Chime, for instance, earned $600 million in interchange fees in 2020. Although the consumer is unaware of the interchange, it is a vital source of funding for many fintech companies. In the end, fintechs must keep in mind that they are, at heart, technology firms.
Two things are essential for understanding this: To begin, a fixed proportion of the transaction price is reserved for interchange fees, regardless of the kind of card used (debit or credit) or the jurisdiction in which the payment was made.
There’s also… By definition, interest rates are not. They are determined by central banks, with the exact rate depending largely on macroeconomic factors. They are lowered in difficult economic times, such as a recession or a once-in-a-generation epidemic, in order to boost spending and restore consumer confidence. Interest rates tend to rise alongside inflation as a means for governments to curb spending and consumption.
For financial technology companies that rely solely or mostly on interchange fees, this is a major problem. Their borrowing costs can get dangerously out of hand, while their earning potential is capped as a fixed fraction of their clients’ purchasing activities.
The fact that these fintechs often give back the interchange fees only adds insult to injury. Over the past decade, we’ve learned that a startup’s customer acquisition rate is a valuable indicator of the company’s future prospects, and that offering large refunds or interest rates is a simple approach to boost this measure.
As a result, they are either running out of runway and seeking capital through stock or debt arrangements to keep the lights on. But runway is finite, and as the macroeconomic situation as a whole has worsened, it has been more difficult to secure further finance and that funding is likely to be reduced or supplied under less favorable conditions.
Inability to adapt
It’s important to remember that this problem is affecting just the newest fintech businesses and not, as one might assume, the more established banking systems. One possible explanation is that there is less of a need for these companies to expand their consumer base. A bank that has been around for a century doesn’t need new customers to ensure its continued success.
However, these established companies’ greatest strength lies in the breadth of services they offer. With the passage of time, they have expanded their offerings to include not only loans and insurance but also credit cards and mortgages. The notoriously staid traditional financial sector will survive the next several years because of its diversification, which provides some insulation from changes in interest rates.
And since banks store and hold deposits, offering interest rates to customers that are typically substantially below those fixed by central banks, they have long enjoyed the cheapest forms of funding.
Most of the new fintech challengers, in comparison, don’t provide nearly as many products. They can rely solely on interchange fees for income, or they might be struggling to get traction with their alternative offerings. Either they haven’t met the requirements to become a full-fledged bank yet, or they’ve chosen to cater to a narrower subset of customers.
Deposits can only be held by banks in the United States. They are more flexible in the goods they can provide, giving them more room to grow and branch out. However, the formal procedure of becoming a bank is time-consuming, costly, and increasingly onerous. It’s not worth it for fintechs, or, more accurately, it’s an issue that can be avoided by collaboration with a bank that welcomes innovative financial services.
There are significant drawbacks to entering the banking industry. It requires a lot of supervision, which is tough for some new businesses to handle. Also, what happens if a fintech firm decides to pivot? The situation then becomes complex.
It’s a logistical nightmare to renounce a banking charter, and it carries some stigma because it’s usually the result of some form of failure or misconduct. That’s not to suggest that never occurs or that there are never valid (and perhaps even advantageous) arguments for doing so. Marlin Bank, located in Utah, merged with a larger investment company and renounced its state charter. However, separations of this sort are never simple for lack of a better phrase. There’s the sticky problem of what to do with old customer data or unsalable inventory. The process is costly in terms of both time and resources.
Many new businesses make the fatal error of assuming that the favorable macroeconomic conditions of the 2010s would continue eternally. This is especially true of fintech startups. That there would never be a shortage of cheap, readily available capital, and that inflation and interest rates would remain permanently low.
No global epidemic would break out. There is not a conflict in Ukraine. Nothing that would cause major disruption to their operations. This shortsightedness will be fatal for many businesses. They’ve cornered themselves by offering a narrow selection of products or by giving out incentives that make switching to a competitor difficult.
This is especially true for companies operating in the business credit card industry that make the majority, if not all, of their money from interchange fees and then return the proceeds to their customers in the form of rebates and interest rates.
McKinsey’s 2022 Global Payments Report expresses similar concerns, stating that many fintech startups’ business models, especially for buy now, pay later firms, have yet to prove their viability in such choppy macroeconomic conditions as rising interest rates and fixed interchange fees.
Evidently, the persistently high inflation rates aren’t a short-term issue but rather something that will be with us for the foreseeable future. This indicates that low central bank rates, the magic bullet that has sustained these very risky business models, are unlikely to be maintained for some time. Those fintechs who make tough calls about the incentives they offer clients or that diversify their product offerings are the ones that will thrive during this time.
This can be done without compromising the core of their offerings. Offering a customer experience that is unquestionably superior than traditional alternatives is, as some of the most successful fintech companies demonstrate, the greatest way to generate volume.
In the end, fintechs must keep in mind that they are, at heart, technology firms. And the way to succeed is to create outstanding software.
Consumers are more likely to pay for premium software if they see clear benefits over using a free option. It frees up alternatives to commission and interchange fees as a source of income. New opportunities, such as features to set you apart from the competition or products to upsell to existing customers, become much more obvious when you frame your business as one that seeks to identify and solve problems, rather than one focused on customer acquisition and transaction volumes.
Importantly, when software is recognized as having equal status to other business assets, fintechs are free to license it to other companies. The easiest approach for established fintech companies to become resilient in the face of the threat posed by their reliance on interchange fees is to actively pursue diversification.
The idea itself isn’t particularly original. Take Microsoft, for example; they profit from OSes, office suites, cloud services, gaming consoles, and portable computers. It is possible to make the same argument about Google, Apple, Amazon, and numerous others. The financial services industry is highly regulated, making expansion a complicated and frequently bureaucratic process.
Developing new capabilities and enabling new revenue streams naturally takes time. It takes skill, capital, and a plan that includes more than just the next quarter to create outstanding software. For many businesses, reaching this level of sustainability is an ambitious long-term goal. It’s important to keep in mind that the macroeconomic climate is still challenging, and that investors no longer view profitability as a negative word or an afterthought compared to expansion.
During the next fundraising round, it will help if you can demonstrate that you are committed to long-term viability and have a plan to turn a profit.
Finally, in light of recent events in the financial services industry, they should evaluate the value of the incentives they currently provide. Already three large banks have failed this year, and countless additional suppliers have either vanished or been acquired. In light of the continuous anxiety, it can be helpful to advertise stability, and more specifically the capacity to create an impression of stability.
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